Euro Small-Cap ETF Crushing It

Europe’s debt crisis is running its course—just look at the red-hot small-cap space.

Europe’s debt crisis is running its course—just look at the red-hot small-cap space.

Europe has been on the mend, and small-caps are massively outperforming their large- and midcap peers.

Still shocking to me is that there’s only one Europe small-cap ETF at the moment, the $1.3 billion WisdomTree Europe SmallCap Dividend ETF (DFE | B-75). That’s likely to change in the near future, but for now, DFE is crushing its large-cap peers in performance, and it remains a solid choice for European small-cap exposure.

In the past year, DFE returned more than 48 percent, compared with a 22 percent return over the same period in the $15 billion Vanguard FTSE Europe ETF (VGK | B-94), which holds large- and midcap companies.

Only a few years ago, investors were running for the exits with market pundits predicting a breakup of the eurozone in one form or another.

But since European Central Bank (ECB) President Mario Draghi’s famous “whatever it takes” speech on July 26, 2012, when he uttered the words: “Believe me, it will be enough,” in reference to the ECB’s stimulus plans to preserve the euro, the European markets took off and never looked back.

Almost two years later, bond yields across the continent are plummeting and stock markets are still rallying.

Two Clear Trends In Europe

Since the day of Draghi’s speech, we’ve seen two clear trends in the European stock market.

One is that small-caps have massively outperformed. The second is that the “eurozone” has outperformed “all Europe.”

Chart courtesy of StockCharts.com

You can see that EMU-focused ETFs like the iShares MSCI EMU ETF (EZU | B-62) and the SPDR Euro Stoxx 50 ETF (FEZ | A-55) are outperforming “all Europe” funds like VGK and the SPDR Stoxx Europe 50 ETF (FEU | A-86).

When selecting Europe ETFs, determining whether you want Europe or eurozone exposure is crucial, since noneuro nations like the U.K, Switzerland, Sweden and Norway make up roughly 50 percent of “developed” Europe’s total market cap.

DFE: Lone Wolf For Now

DFE is interesting not only because it’s the sole small-cap Europe play, but it also selects and weights its holdings by dividends. More importantly, for better or worse, it targets all developed European countries, not just the eurozone.

The common explanation given as to why small-caps are outperforming is that they’re more closely tied to the recovery in the local economies, as opposed to large-caps, many of which tend to be multinational exporters.

As expected, DFE carries a heavier weighting to sectors that are more cyclical in nature—industrials make up 26 percent, while consumer cyclicals make up 15 percent. In comparison, those two sectors make up 12 and 11 percent, respectively, in VGK.

Looking at valuations, with DFE on a tear since July 2012, one would expect some frothy valuations. Yet DFE has a trailing price-earnings multiple (P/E) of 19.37—slightly less than VGK’s P/E of 20.7, which is surprising because DFE is small-cap focused.

In comparison, the cap-weighted MSCI Europe Small Cap Index—used as our benchmark for European small-caps in our ETF Analytics reports—has a trailing P/E of 36.13. True to its “dividend” focus, DFE also sports a portfolio yield of 2.66 percent, yielding roughly 100 basis points more than our MSCI benchmark.

Not only does DFE have a “value” tilt, it also outperformed the benchmark over the past year, while taking on less market risk (beta of 0.94). In fact, we’re even seeing statistically significant annualized alpha of more than 10 percent, which is quite impressive.

Source: Bloomberg

Looking Ahead

State Street Global Advisors recently filed for two ETFs in the space that look interesting—the SPDR Stoxx Europe Small Cap 200 ETF and the SPDR Euro STOXX Small Cap ETF. The first will capture “all Europe” small-caps while the other will capture eurozone small-caps.

I certainly welcome these filings. That said, even after the new launches, I wouldn’t be surprised if DFE remains the de facto way to play small-cap Europe, due to its first-mover status, stability and stellar performance over the years.

Recent news of a surge in consumer confidence in the eurozone—it’s been 20 months now since the Draghi-induced European “rebound” began—only bodes well for a fund like DFE.

While the two State Street filings will certainly add another edge to play Europe’s ongoing recovery, if you’re still bullish on Europe, DFE is solid choice, and it’s very deserving of our Analyst Pick for European small-cap exposure.

At the time this article was written, the author held no positions in the securities mentioned. Contact Dennis Hudachek at [email protected], or follow him on Twitter @Dennis_Hudachek.